Corporate Finance Overview

What is Corporate Finance?

Corporate finance is a part of finance that usually focuses on how businesses handle different fields such as funding, capital structure, accounting, and investment decisions.

It focuses on increasing shareholder value through long-term financial planning and strategy implementation. Besides, Its activities also include anything from capital investment to tax planning.

Corporate finance departments are usually responsible for managing and overseeing their companies’ financial activities and capital investment choices. These decisions include pursuing a planned investment and funding it with equity, debt, or both.

It also considers the activities and transactions that involve raising capital to start, grow, and buy a business. It is directly tied to business decisions that have monetary or financial consequences. It can be a link between the capital market and the company.

Corporate finance specialists are ultimately responsible for optimizing a company’s capital structure by lowering its Weighted Average Cost of Capital (WACC) as much as possible. The techniques and analyses used to prioritize and distribute financial resources are also included in.

The ultimate goal is to optimize a company’s value through resource planning and implementation while balancing risk and profitability. The corporate sector also includes whether or not dividends should be paid to shareholders and, if so, at what rate. 

This department also manages:

• Current assets
• Current liabilities
• Inventory control

The chief financial officer of a corporation is frequently in charge of the company’s financial operations (CFO).

Corporate Finance activities

The main objective of corporate finance is to maximize shareholder value by making prudent decisions about capital investment, financing, and dividends. Corporate finance can e divided into three main essential activities, such as:  planning, capital financing and dividends and return on capital. 

Each of these activities requires a blend of financial theory, quantitative methods, and practical business knowledge. The ultimate goal is to make informed decisions that enhance the value of the company for its shareholders. 

Planning

The first activity is planning where to place the company’s long-term capital assets to generate the highest risk-adjusted returns is part of investing and capital budgeting. This primarily entails deciding whether or not to pursue a particular investment opportunity.

A corporation can identify capital expenditures, predict cash flows from proposed capital projects, compare planned investments to projected income, and decide which projects to include in the capital budget by using financial accounting techniques.

In addition, financial modeling is a technique for estimating the economic impact of a potential investment and comparing different projects. When comparing projects and selecting the best one, an analyst would frequently use the Internal Rate of Return (IRR) and Net Present Value (NPV).

Capital Financing

It determines the best way to finance capital investments by using the company’s: equity, debt or both of them.

For example, selling firm shares or issuing debt instruments in the market can provide long-term funding for large capital investments.

Balancing the two sources of finance, equity and debt, should be carefully handled because too much debt can increase the danger of repayment default. At the same time, too much equity can dilute earnings and value for original investors.

Dividends and Return on Capital

This activity requires corporate executives to decide whether to keep a company’s excess earnings for future investments and operations or distribute them to shareholders in the form of dividends.

Retained earnings that are not given to shareholders can be used to fund a company’s growth. This is frequently the best source of funds because it does not require extra debt or diminish equity value by issuing additional shares.

Generally, in the business environment, if the business managers believe that they can achieve and earn a higher rate of return on capital investment than the company’s cost of capital, then they should go for it. Otherwise, they have to pay dividends or share buybacks to return excess capital to shareholders.

Capital Investment

A company’s capital investment is the purchase of physical assets to achieve its long-term business goals and objectives. Assets obtained as capital investments include real estate, manufacturing buildings, and machinery.

Corporate finance responsibilities include capital investments and long-term capital deployment. Also, capital budgeting considers the heart of the capital investment decision-making process. 

For example, a venture capital firm is one of the sources of capital investment.

In the meantime, a company’s capital budget:

• Identifies capital expenditures
• Forecasts future cash flows from proposed capital projects
• Compares planned investments to prospective proceeds
• Decides which projects to include in its capital budget through capital budgeting

Making capital investments is one of the most corporate finance tasks with significant business implications. Poor capital planning, such as excessive or underfunded investments, can settle a company’s financial position, either by higher financing costs or insufficient operating capacity.

We can understand capital investment in two different ways:

1. Capital investment in a firm might be from an individual, a venture capital organization, or a financial institution. The funds can be given in a loan or a share of future profits. In this case, capital is defined as money in this context.
2. A company’s executives may invest in the company’s capital. They can invest in long-term assets such as equipment to help the company run more efficiently or expand more quickly. In this case, capital refers to tangible assets in this context.

A new business could seek funding from various sources, like venture capital firms, angel investors, and established financial institutions. When a new firm goes public, it attracts substantial amounts of capital from many investors.

In addition, a well-established business might make a capital investment from its financial reserves or take out a bank loan. In order to finance capital investment, it may issue bonds or stock shares.

Increasing operational capacity, gaining a larger market share, and generating more revenue are the most common reasons for capital investments. Any company can make a capital investment in the form of equity in another company’s complementary operations.

Although a company’s operating cash flow is always the preferable option for capital investment, it may not be adequate to cover the anticipated costs. As a result, it’s more likely that the corporation will seek outside funding.

Capital expenditure is intended to benefit a company in the long run, but it can have short-term drawbacks:

• Ongoing capital investment tends to slow earnings growth in the short term, which is never good for public business stockholders.
• The value of a company’s outstanding shares is diluted when it issues additional stock shares, a common funding option for public corporations. Existing shareholders are often unhappy when their stake in the company is lowered.
• Stockholders and analysts pay close attention to the overall debt a firm has on its records. The debt payments may slow down the company’s future growth.

Capital Financing

Corporate finance is also in charge of sourcing capital, whether it is in the form of debt or stock. For example, a firm can borrow money from commercial banks and other financial intermediaries or issue debt securities on the stock exchange through investment banks. 

When a firm requires a considerable amount of funds for commercial expansion, it may choose to sell stocks to equity investors. Capital financing considers a balancing act of deciding on the relative amounts or weights of debt and equity. 

In addition, too much debt might raise default risk, while relying excessively on equity can dilute earnings and value for early investors. Finally, capital financing must supply the funds required to carry out capital projects.

A company’s financial capital keeps it going, which allows you to purchase items and services such as office and factory equipment, vehicles, web design services, and liability insurance. For example, you pay your employees’ wages with capital if you have them.

In debt financing, you can borrow money to cover the costs of running a firm. But, in equity financing, you sell a piece of your company’s ownership, such as issuing stock.

Capital Financing Types

Below we will see how the two basic kinds of capital finance operate: 

A) Capital Finance: Equity

It has to sell a portion of the company’s ownership in exchange for capital when a firm uses equity financing. Meaning that the business can raise money through public stock offers. 

But it can also raise money through private stock offerings to venture capital firms or individual investors. Unlike debt funding, the business doesn’t have to pay interest or make monthly installments.

Selling an ownership stake in the company through issuing stock is an example of equity. 

The disadvantages of Equity are:

1. The business can lose some control when it is not the sole owner. Offering shares to tens of thousands of investors may cause less of a threat to the business authority than selling them privately to a powerful venture capital firm. 
2. Federal rules and required documentation make a public stock offering costly.

B) Capital Finance: Debt

Taking on debt is an option to sell the company’s equity. Also, borrowed money is the most common type of debt finance. Short-term or long-term loans can be high-interest or low with or without cosigners or collateral.

Most businesses that rely on capital finance aim to strike a balance between the two forms. For example, not getting into so much debt that business payments eat up all its earnings. 

Another form is to reduce the amount of selling equity that it’s no longer within your company. Furthermore, the benefit of using any of these methods of capital finance to borrow money is that the company can retain control over its business.

The two main disadvantages of Debt are:

1. The firm must make regular loan payments, including interest, or its capital will be depleted in the future. 
2. Businesses can lose their assets or go bankrupt if they can’t make payments.

Short-Term Liquidity

The ability of a company to meet short-term financial obligations is referred to as short-term liquidity. The link between current liabilities and current assets is measured using short-term liquidity ratios.

Usually, current liabilities, trade creditors, bank overdrafts, PAYE, VAT, and other amounts due within the next twelve months are examples of short-term financial commitments. Also, a business must be able to satisfy all of its current liability commitments when they become due.

Corporate finance is in charge of short-term financial management, which involves ensuring sufficient liquidity to continue operations. Short-term financial management refers to managing current assets, liabilities, working capital, and operating cash flows. 

It involves having sufficient current liquid assets to prevent a company’s activities from being disrupted. Obtaining additional credit lines or issuing commercial papers as a liquidity backup may also be part of short-term financial management.

There are two main short-term liquidity ratios: 

Current Ratio = Current assets / Current liabilities

Acid Test Ratio = (Current assets - stock)/ Current liabilities

1. Current Ratio

The current ratio measures a company’s ability to satisfy its short-term financial obligations. This ratio assumes that, if necessary, all current assets can be converted to cash promptly to pay all current liabilities.

2. Acid Test Ratio

The acid test, known as the quick ratio, is a modified version of the current ratio that provides a more conservative measure of short-term liquidity. Stock and work-in-progress are subtracted from current assets in the acid test ratio.

This strategy is more cautious since it realizes that stock can’t always be turned into cash at face value.

To sum it all up, corporate finance studies how companies fund their operations to maximize revenues while minimizing expenditures. It deals with the day-to-day operations of a company’s cash flows and long-term financial objectives, such as issuing bonds.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Appropriation Account
• Industrial REITs
• Public Companies
• Solvency Ratio
• Taxation